I’m a Professor of Economics at University College, Dublin. I have a PhD in economics from MIT. I worked for the Federal Reserve Board from 1996 to 2002, regularly briefing Alan Greenspan and working on the FOMC's macroeconomic forecast. From 2002 to 2007, I worked for the Central Bank Ireland and attended many meetings at the European Central Bank.
My research on macroeconomic issues has been published in many of the world's leading economics journals. These days, in addition to my research, I teach classes, supervise PhD students and comment on macroeconomic and banking issues with a particular focus on Europe. I’m also a member of the European Parliament Economic and Monetary Affairs Committee’s expert panel of advisers on monetary policy. You can find out more about me at www.karlwhelan.com and follow me on Twitter at @WhelanKarl.

How Is Bitcoin Different From The Dollar?

As Bitcoin goes through another day of crazy price fluctuations and huge publicity, this time courtesy of the U.S. Senate, I recommend two readings for those interested in putting the Bitcoin phenomenon in historical context.

The first is this article by my colleague Stephen Kinsella. Stephen’s key point:

Bitcoin has no use value, only exchange value, and because it is has no worth in use other than what others are willing to pay for it, it is always in a bubble: these happen when prices of assets get dislodged from their fundamental value. So Bitcoin is the perfect bubble.

Now the obvious question that this raises is the following: Is Bitcoin so different from the dollar? A dollar bill also has no use other than what people are willing to pay for it. And if people decide they wish to trust the people who create Bitcoins more than their own government, then perhaps it could be an alternative medium of exchange.

Stephen partially gets at the answer as to why Bitcoin differs from the dollar. It is “a currency not backed by any state – meaning nobody has to take it as payment.” The fact that the U.S. government requires payment in dollars in itself creates a direct demand for dollars that cannot be replicated by Bitcoin.

History shows, however, that the state’s involvement in money goes deeper than merely requiring tax payments in its chosen currency and this history is useful for understanding the likely limits to “private monies” like Bitcoin.

My favorite article on this topic is Two Concepts of Money written in 1998 by legendary British economist Charles Goodhart. I strongly recommend that people interested in Bitcoin read it.

Goodhart argues that states have essentially always been in control of monetary systems. He emphasizes that governments have always viewed seigniorage as a useful form of revenue and are unlikely to allow this source of revenue to be replaced by a private source of money.

Right now, Bitcoins are effectively irrelevant when compared with the larger payments system, but those who anticipate it expanding to be widely used might ask how sure they are that private monies of this type would actually remain private. Once big enough to be termed a success, any such currency would attract more attention from governments than a cursory Senate hearing.

Goodhart also shows the theory that private money can emerge as a solution to the inefficiencies of barter has little historical backing. For example, while people often believe that precious metals were adopted over time by the private sector as a useful medium of exchange, in practice people could not be sure whether the metallic content of coins were equal to stated amounts.

Only when governments standardized and verified such coins – and provided security for mints – were coins widely used as a medium of exchange. Goodhart notes that much of the Roman empire went from a monetary economy back to barter after the empire’s decline. Bitcoin enthusiasts may believe that problems with security and verification are less likely to affect a digital currency. Time will tell us the extent to which that is true.

Advocates of Bitcoin enthuse about its commitment to limiting its supply of virtual coins. Goodhart’s paper discusses whether such commitments from private providers of money can actually be credible. He concludes such commitments probably run against the interest of those who control these currencies and so they should not be trusted. Blind trust in the people behind Bitcoin may turn out to be no more sensible than blind trust in the U.S. government, and quite possibly less so.

There’s no doubt that Bitcoin is an interesting invention, useful at a minimum for provoking good classroom discussions in Money and Banking courses about what exactly is the meaning of money. But people should be wary of investing large amounts of their savings in Bitcoins. History provides plenty of reasons to suspect that private money is unlikely to work. Maybe this time is different. Usually it’s not.

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You’re funny. “Bitcoin” is different from the dollar, in that the dollar is backed by the USA’s government – whereas “Bitcoin” is …man, we don’t even know who invented it. Considering that admitting to trading in bitcoins is a good way to get your bank account closed, they’re just a couple steps shy of being illegal. I’d say there’s differences, yeah.

According to recent history, what a bank does is not a good indicator of what’s legal.

Are Chuck-E-Cheese tokens illegal? They’re a private money. If everyone in the world started accepting Chuck-E-Cheese tokens as payment for goods, would it suddenly become illegal?

Who invented the dollar? You don’t know that either. Why does it matter, when anyone so inclined can check its source code and validate that it’s doing exactly what it should be? Can’t do that with a dollar bill.

Always interesting to see Marx quoted in Forbes. Use-value is a property of commodities but not money, so the idea that a form of currency has no use-value is self-evident and applies to the dollar, pound or yen. Perhaps a more interesting question is whether or not Bitcoin actually constitutes a currency at all which would actually call into question whether it can with any validity be used as a measure of the exchange-value of a commodity. If not, then it cannot be considered a currency but a commodity in and of itself, which theoretically has exchange value given that it can be traded on the markets and presumably exchanged for real currency. Technically it has a use value as well because the definition of use value in classical political economy is “any thing necessary, useful or pleasant in life.” So in the sense that these provide some degree of happiness or satisfaction to the purchaser in the same way that a movie ticket or rubber chicken would, Bitcoin would provide the same type of use-value. Of course, much like the vast majority of commodities on the market today, Bitcoin is essentially useless when it comes to satisfying a real human need.

I feel like I’ve walked into a conversation at a party that has been going on for quite a while…

I’ve never heard of Bitcoin and after reading the article I still have no idea what it is. I mean, I like to think of myself as fairly well informed but this is the first time I am hearing of this “thing.”

You criticize Bitcoin’s limited supply as a “promise” by its creators, and that “blind trust” is required to believe that the supply will in fact be limited.

This is incorrect and ill-informed. Bitcoin’s supply is directly limited by the mathematics in the protocol, and literally cannot be changed unless the entire Bitcoin network approves the change. The same network whose own bitcoins will lose value if they approve the change.

Every single bitcoin that is, was, and ever will be can be traced back to its legitimate creation – authorized by the Bitcoin protocol and accepted by the entire decentralized peer-to-peer mining network. There simply is no way to make more on the sly, or counterfeit them.

Very little in life is permanent and fixed. For example, with productivity growth, a fixed money supply implies deflation which is generally undesirable. That would mean that new Bitcoins could be created without causing Bitflation. Bitcoin could also be overtaken or outlawed by government.

If Bitcoin was taken over or outlawed by government, then that has nothing to do with “blind trust” of its creators’ intentions.

But again that’s beside the point. Mathematically speaking, new bitcoins are created approximately every 10 minutes. Right now there are 25 bitcoins made every 10 minutes, in the future that will halve to 12.5, and further to 6.25 and so on. Eventually, it will reduce to effectively 0.

This is all hard-coded in the software that drives Bitcoin. And it can only be changed when the people who run the software agree to ‘update’ the software.

Those people are all over the world, under every jurisdiction imaginable.

That makes it pretty unlikely that anyone will convince them to change the rules for the benefit of one government, or to create inflation that will reduce their Bitcoins’ value.

I have no blind trust in the creators of Bitcoin nor in the creators of the dollar. The difference is, I can’t watch and verify the legitimacy of every dollar created. Bitcoin, I can.

I like the bitcoin deflation and there is no need to create more once we reach the $21 million max bitcoin. Nothing prevent anyone like you to change bitcoin’s restriction to create more, it’s a total free market, just like you can create your very own virtual currency (like litecoin, feathercoin, etc) where the sky is the limit in the number of coin creation, but I’ll stick with the current version. So at that point, there will be a fork, one for those who wants the bitcoin lalaland of printing nirvana like you, and one for those who wants to stick with the $21 million max. Yes, I will have to pay more in fees for transfers to satisfy the miners (which will be called the transferers/validaters then), but our bitcoin be worth more. And if we need to go into even smaller denomination, no problem. Guess which one I believe will have the larger market share? :-)

“A dollar bill also has no use other than what people are willing to pay for it. “??!?!? Incredible. What about the federal, state and local governments in the US, which will send you to jail if you don’t pay your taxes each year using US dollars.

Meanwhile, bitcoin mining firms are engaged in some sort of perverse arbitrage, wasting hundreds of dollars worth of power to generate a single unit of this fantasy currency. We’ll soon have to build new power plants dedicated solely to powering the legions of these overzealous enterprises, wasting tons of scarce resources in the real world and polluting our environment, all so anti-government fetishists and criminal lowlifes can engage in such folly. I can’t wait for this tulip currency to crash down to the ground, taking those douchey Winklevii with them.

But the point is the US government does use them – it issues them and if you operate a business in the US, you have to pay taxes with them. And if you’re employed by that business you have to pay taxes on your income with them. The currency is backed by the government, which is what gives it its value. It’s completely different from say, using baseball cards or tulips or bitcoin – whose value truly is in the eye of the beholder.

As a pure medium of exchange, I think that statement about the dollar is correct.

That the US government require dollars for payment is important — and I discuss this in the article as a key point — but it wouldn’t have to be a permanent institutional feature. The government could decide to accept Bitcoins for payment but, for reasons outlined above, it’s very unlikely that they would.

Yes, I agree. By that sentence I merely meant that, absent all the institutional stuff that goes with its US government approval — a dollar bill is just a piece of paper. So we’re not really disagreeing here.

Getting that sinking feeling like you missed the opportunity to invest in the most significant innovation since the introduction of paper money 1400 years ago?? I wouldn’t worry too much. It’s not too late to get some bitcoin. It could very well go to $10k or a million before settling in for the long haul.

Also there are other competing currencies, like peercoin – which is more energy efficient and more secure – that you can get in on right away. That coin is currently significantly under-priced.

Whatever you do, rather than focus on what you believe are the bad facets of digital currencies and focus, go ahead and focus on the very real problems they solve. This will lead you to the right investment.

But that’s not true. They have enormous utility. Just like a small percentage of gold’s value lies in the fact that it has a few industrial and cosmetic uses, bitcoin’s value is derived from its ability to send money from one place to another for very low fees.

Greg, this is the biggest argument against investing in bitcoin. It doesn’t matter if bitcoin supply is limited. Someone else can start a new digital currency, like peercoin. And when that reaches a mature level another currency can be created, then another and another. This will create inflation across all of the digital currencies. Traditional currencies are stabilized (or destabilized in some cases) by the issuing countries. This used to be done by printing currency or pulling currency out of circulation. Now it is done by setting interest rates to control lending since society today is so debt driven. There is nothing in Bitcoin to create this stability or coordinate exchange rates with other currencies, digital or traditional. And that is why I believe that Bitcoin will fail as anything other than a fringe currency. If it becomes too main stream, the creation of other digital coins trying to “get in on the action” will assure its devaluation and destruction.

Your parenthetical “or destabilized in some cases” says it all. There is nothing fundamentally different between competing fiat currencies and competing digital currencies, except that in the case of digital currencies they actually will be competing (ie no money monopolies) and holders of the currency can put their faith in cryptography and math (ie full transparency) rather than putting their faith in monopolistic, behind the curtain currencies.

This vision of a scenario with consumers choosing the currency they wish to hold and use based on the stability of them is one the very well respected economist, Hayek, held as being key to stable economies.

You are correct, there will be volatility and bitcoin may not be the leader in the end. But it is an incredible invention that solves some very real problems of the world. And these competing currencies will actually add more stability to the ecosystem then they will take away. And, given the amount of economic activity that happens every day in the world there are enormous sums of money that will be rewarded for going into these currencies. There is just too much incentive for too many people for this not to happen.

You say that the dollar is “backed” by the government, but that’s not actually true. The US government exerts no control over the value of a dollar. In fact, over the past 100 years the value of a dollar (measured, for example, against a basket of commodities or precious metals) has declined over 95%.

The problem is that “backed by the government” is essentially meaningless. Governments provide little value with their easy-to-forge, easy-to-manipulate currencies. Top cryptocurrencies are very hard to forge, and, given ample capitalization, will be difficult to manipulate. They are not, of course, currencies, they are commodities. And that is why they don’t compete with true currencies. Government currencies are valued because of enforcement. Bitcoin, by providing authentication, fraud prevention, and transaction services, has value because of the services it provides.

The aspect of bitcoin that is most overlooked is that fact that it is a protocol. TCP/IP (the internet) is one, HTTP is one. Protocol is backbone. HTTP is built on top of TCP/IP, and the Yahoos/Lycos to now Google, Facebook, AirBnb and who knows what’s next, are built on top of HTTP.

That is the power of a network that is open source to developers and computer scientists. The day that a whole library of applications, and scripts can be built on top of a dollar bill is the day that Bitcoin becomes exactly like the dollar.

And food for thought: Myspaces, Friendsters, AOL – websites can come and go. But how many HTTP’s have there ever been? How many TCP/ip? Is there are JoeTTP? A Mary-TTP? In the world of protocol – first movers usually win. I cannot claim to know Bitcoin’s exact future by any means — but everything is pointing in its favor.

The reason (some) people have accepted Bitcoins as a form of currency is not based on trust on “people behind” it. It’s based on trust on the mathematical properties of the very specific bitcoin algorithm, which guarantee several important traits for the currency, such as anonimity and irreversability of transactions. Only if there are serious mathematical flaws in the algorithm (and there’s been a few years of it being publically available to study by academia) will the currency be in danger.

The name “private currency” gives a wrong ideea about how bitcoin operates. It is primarly a distributed currency that is constantly being checked by everyone participating in the bitcoin network. Bitcoin is ofcourse not invulnerable but as far as we can currently tell it can only be attacked if the majority of bitcoin machines are controlled by malicious entities. While that is a possibility, the more individuals participate in bitcoin, the safer it is.

It’s laudable that people with an economic background look at bitcoin critically but you need to first understand why bitcoin took off when other alternative currencies didn’t (and why it took off to such an extent with the underground market – drug dealers are not known for their utopianism). Bitcoin has properties by design that give it utility that normal currencies will never have – and quite frankly that utility is to be resistant to central control, hard to trace and hard to tax.

Now do i believe you should pay hundreds of dollars for a bitcoin ? No, there probably is a speculation bubble right now and it might burst at some point. But bitcoin’s utility as a currency is still real. And while some governments may well wish to outlaw bitcoin transactions actually eliminating it once the genie’s out of the bag so to speak would be as hard as eliminating online piracy or spam.

You are aware that Bitcoin is an open-source? So, there are many different coins already (primecoin, litecoin, etc) all with different block-chains. Are you suggesting the govt. will co-opt / repress all of these? If they did, there would be 10 more the next day. It’s like a hydra. They would be playing catch-up to no end.

As Steven notes above, the fact that Bitcoin can be copied by other people is an argument against this kind of currency being successful.

If, as emphasised by many of the commenters here, the thing that Bitcoin really has going for it is a cool algorithm that ensures a limited supply then there will always be someone else out there with an even cooler algorithm. And then someone else.

It’s a bit like investing all your money in IBM in the 1970s because you’re sure computers are the next new thing. Even if digital money is going to be a success, why does it have to be Bitcoin?

Only in this case, competition with a dominant existing currency and the fragility of establishing private money means this probably isn’t the next new thing.

It isn’t always the “best one” that wins out. Once upon a time, VHS and Betamax were at war and most argued that Betamax was the superior format (which it was) – yet VHS garnered more market share, faster, and Betamax died. The same thing happened with HD-DVD and Blu-Ray.

It really doesn’t matter if there’s a “better” Bitcoin in someone’s head somewhere. If the Bitcoin is embraced globally, nobody will care about another cryptocurrency.

Or investing in Napster in the 1990s is perhaps an even more salient example than IBM. Digital music obviously completely transformed the entire music industry, but the pioneer in this space was a complete failure, in no small part due to legal reasons.

That being said, investing all of your money in IBM in 1970 would have made you fabulously wealthy. Sure IBM isn’t the only player now. But the first to market, despite flaws, often remains a dominant player.

In theory bitcoin is a decentralized currency not controlled by any special interests also creation of this currency is achieved by a fixed set of principles that stops it from being manipulated. In reality bitcoin has a creator and an owner just like any other currency and it is up to the principles of that group to ensure the integrity of the currency.

“For example, with productivity growth, a fixed money supply implies deflation which is generally undesirable. ” The number of Bitcoins can indeed only increase by Bitcoin mining, a very processor-intensive operation and also mathematically limited to a maximum. Bitcoin, however, does have an implicit way to increase money supply: alternative Bitcoin-like cryptocurrencies (which already exist) to which people will flock when Bitcoins are hoarded.

“Blind trust in the people behind Bitcoin may turn out to be no more sensible than blind trust in the U.S. government, and quite possibly less so.”

Which just reveals the fundamental misunderstanding. WE are “the people behind Bitcoin.” The people participating in its use and those who are mining it, those maintaining the blockchain. There is no organization or individual regulating Bitcoin to trust, it’s completely decentralized. While with fiat currency, you put ALL of your faith in the government (in our case, the Federal Reserve) to do the right thing, so your money holds its value and they’ve got a long, LONG track record of NOT doing the right thing, and devaluing the currency relentlessly.

So you tell me. Do you put your faith in a central authority consisting of human beings…or do you put it in cryptography?

As you stated in the article, “Goodhart notes that much of the Roman empire went from a monetary economy back to barter after the empire’s decline.” The debasement of the currency was a major reason for the decline of the Roman empire, which is apparently something that is being conveniently forgotten.

Bitcoin is a very interesting experiment in Capitalism since it is a currency that has no involvement with any government or other central authority. However, that may change if its value continues to increase.

I find it very difficult to read an article like this when almost every point made is based on a lack of understanding of how Bitcoin works. You may be highly educated in economics but you are clearly uneducated on how Bitcoin functions.

Bitcoin is not Private Money. Bitcoin is a peer to peer network that is not owned by anyone. It cannot be controlled or taken over by anyone including governments. Bitcoin cannot be shut down or turned off.

The writers of the books you quote could not have fathomed a currency system like Bitcoin when they wrote those books.

People will use Bitcoin for an endless number of reasons but mostly because it does the job of money better than money. It is a frictionless currency that can be sent to anyone anywhere in the world instantly for next to nothing, with no middleman taking a piece and quicker than you can get change for the dollar in your pocket.

People will not turn to Bitcoin copies. Would you sign up to a copy of Facebook that does the same thing but with no infrastructure? The basic Bitcoin infrastructure is already in place and growing at a record pace. Plus, Bitcoin can change and adapt new functionality but only if it has a majority consensus of acceptable changes to the network.

We do not need to trust the people who create Bitcoins. Bitcoins are not created by people, they are created by an open source program and algorithm that has been reviewed by thousands and anyone that can read code.

Other Fear Mongering Nonsense:

Bitcoin is not truly anonymous. The Dollar has more anonymity than Bitcoin. Bitcoin has a ledger anyone can see of every transaction ever made. In the future this ledger will become a great tool for law enforcement to track down criminals. The Dollar has no record of transactions and is the currency of choice for illicit activity.

Bitcoin is not a Ponzi scheme. By that definition all stocks would be considered a Ponzi scheme. Should Bitcoin continue to increase in use and value the original risk takers should be rewarded just like any stock holder. If Bitcoin fails like many think it will those holders will lose.

Bitcoin is not beanie babies. Bitcoin has been brought to you by the Techies of the world. The same people that create and maintain this amazing modern technical world we live in. It is a very complex system. Unfortunately, many experts of other fields such as economics jump to conclusions without really understanding how it works. Techies created it. Techies built it up. Techies believe in it. And, Techies of the world are buying it.

Bitcoin’s vitality does not make it unusable as a currency. Bitcoin is in its infancy and is nowhere near ready for prime time. As bitcoin gains acceptance and grows in value, depth, liquidity and stability will follow. At this point the average person doesn’t even understand how it works much less put a concise value on it. And yes, it is all speculative as most startups are. How do you price something that could change the world of finance forever or be worthless in a few years? It could hold a large percentage of the world’s currency value or it could be worthless or anywhere in-between.

I hate the idea of a virtual currency. However, I hate the fact that most nations money supply (the U.S., Britain, Germany, among others) is controlled by private families like the Rothchilds and Rockafellers.

Let’s stop pretending that “federal reserves” are even remotely federal and hold any sort of “reserves.”

“If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and the corporations which grow up around them will deprive the people of all property until their children wake up homeless on the continent their fathers conquered.”

- Thomas Jefferson

I guess you can call the great Thomas Jefferson a prophet because America is sinking in quick sand while a small group of ultra rich corporate elitists, who are owned by the real power players (international bankers), aer living like kings.

Western capitalist ideals have brainwashed the masses just like religion did during the medieval era. If you’re poor, it’s because your stupid right or that’s gods will. Eat worms for breakfast, you’ll be better when you’re dead. In the meanwhile, help the elite live in palace and eat endangered caviar.

Although a simple question, “What gives Bitcoin value?”, the answer is not as simple as the question. What gives Bitcoin it’s value, can best be answer by the formula

PB = (SW + TX) / BC

The value of a Bitcoin is derived from the total value of the Bitcoin used for storage of wealth (SW) plus the total amount of the Bitcoin required for concurrently transacting in it (TX). The sum of these two numbers divided by the amount of Bitcoins in circulation (BC) (currently 12.2 million, ultimately 21 million), will give you the price of Bitcoin (PB).

There are estimates of the total amount of gold in existence (mined) in the $10-13 Trillion range. If $1 Trillion (10%) of the amount of wealth that would have gone into gold, instead lands in Bitcoin, that would increase the price of Bitcoin to ($1Trillion + TX) / 12.2 million, or by $83,000 per Bitcoin. Remember, this leaves out the TX component, which will further increase the price of Bitcoin. Over time, funds will shift from other asset classes being used for wealth storage to Bitcoin.

There are many advantages to storing wealth in Bitcoin as opposed to specifically gold, for example, as you can divide Bitcoin into very tiny pieces (difficult with gold) and you can send Bitcoin to someone on the other side of the planet within minutes (impossible with physical gold). These use cases illustrate why Bitcoin is a good alternative for gold (and other assets) for storage of wealth.

From a transaction perspective, as more citizens, businesses, and governments transact in Bitcoin, the amount of ‘wealth’ that must be placed into Bitcoin must be large enough to allow these transactions to happen.

For example, if it becomes common place for real-estate purchase payments to be processed via Bitcoin, then the amount of value in Bitcoin required to allow this to happen will need to be as large as the current working set of real estate transactions in progress. This logic applies to online sales and brick and mortar sales. If, on a daily basis, $250 Billion is required to allow all Bitcoin transactions to occur, the Bitcoin price only in terms of TX requirements, is $20,500.

The price of Bitcoin (PB) = (SW + TX) / BC. SW and TX will both change as time passes. In geek terms, SW, TX, and BC are functions of time f(t). Therefore to more accurately predict the price of Bitcoin, you need to estimate these two components for a given time, and then divide by the number of Bitcoins in circulation. BC can easily be obtained from many websites and is updated live.

Bitcoin works well as a storage of value and for financial transactions, therefore it will often be used as a substitute for both currency as well as common wealth storage assets (e.g., gold). Bitcoins utility (global register – the block chain) is what makes this possible. The worth of Bitcoin comes into play because of this utility, wealth storage and transactions will happen ontop of this platform. And using the formula above, the price of Bitcoin (PB) can be computed by estimates of these two quantities.

The US dollar is privatized currency. Federal Reserve debt notes are private currency. Congress didn’t issue the money via the treasury. The private Federal Reserve did by borrowing it into existence. Nothing fictional about this. It’s all out there. So why all this talk about how Bitcoin is a private currency instead of US dollar. Nope. No difference there. The only real difference is that US dollars are the only form of currency accepted for payment of taxes and for purchasing oil. If the oil producers started accepting Bitcoin and the US gov’t decided to honor payment in Bitcoin, there would be no difference at all between the two. With the exception that Bitcoin isn’t borrowed into existence at interest rates